One idea floated in the current presidential race is temporarily imposing price controls on credit card rates, limiting them to 10%. While this may seem appealing to consumers living in a world where the average credit card interest rate is 22.76%, such price controls could have a potentially adverse—and possibly catastrophic—impact on the U.S. credit card market. This move would likely disrupt capital markets as well, with investors losing confidence in the revenue stability of lending contracts.
In a recent Impact Note, Brian Riley, Director of Credit at Javelin Strategy & Research, examined how such a move would affect the credit card industry. His conclusion: Market-driven, risk-based lending benefits both card issuers and cardholders.
Slashing Revenue Sources
Credit card issuers derive their income from two channels: interest and non-interest. Interest income is revenue earned by lending money, while non-interest income is generated through fees and interchange. The interest side of the equation currently represents about three-quarters of credit card revenue. What would happen if that revenue were slashed to the bone?
With rates capped at 10%, interest revenue would plummet. A conservative lender might seek out accounts classified as exceptional, which represents about 21.2% of the U.S. consumer base. As a result, most households could not rely on credit as a budgeting tool or as emergency relief after unexpected financial events.
Without some form of relief, such as a federally driven subsidy to lenders for under-market rates, issuers’ interest income would immediately erode. The provision for loan losses would increase, and collections would become less effective as credit lines are closed. There would be an immediate impact on the return on assets in both cases, shifting from an optimistic estimate for 2024 of 2.30% to a negative position of more than 600 basis points.
Currently, low-risk customers receive rates below 20%, which is equivalent to the prime rate plus a margin of 11.24% for purchases. Riskier customers who qualify for a credit card pay closer to 30%, with rates around prime plus 21.24%. The cardholder’s credit profile drives the determination of a risk-based price.
“Risk-based pricing says, ‘This guy’s an old baby boomer, and he’s got a house and a job and an established life,’” Riley said. “’I’m going to price him differently than the new kid on the block that has no credit, right?’ That’s how the model works. When you start playing with that dial that says I used to lend between 19% and 29%, but now I have to do it for 10%—it’s illogical.
“If you take all my profit out of that line, I can’t run a business,” he said. “If I need 8% to cover my operational costs, that 10% maximum interest level doesn’t even cover my risks. The only thing I’ll end up doing is lending to the top 20% of the cardholders. That’s it.”
Building a Customer Portfolio
Card issuers want a broad spectrum of incomes among their cardholders. Wealthier, more-established customers are the most reliable and creditworthy, but they are also the group most likely to pay off their balances every month, depriving issuers of that income revenue. Younger, less creditworthy customers are more likely to carry a balance on their cards.
“You want people to ebb and flow,” Riley said. “They run their bills up at Christmas. When they get their tax refund, they pay it down. They run it up on vacation, and then they get back and the kids are in school, so they pay it down a little more. Before the Great Recession they used to call it perma-debt, because people get into this whole cycle.”
Limiting rates to 10% would likely cut that family completely from the credit card business. They may not be stable and reliable enough to merit a 10% rate, even though they make an effort to pay off their balances when they can.
Collateral Damage
If such a mandate were to proceed, the change would likely require an act of Congress rather than a presidential order. But that’s not the only roadblock for this proposal.
Capping credit card interest rates would also trigger a wave of ramifications for other areas of the economy. If credit card contracts could be nullified, the expectation would be that auto loan contracts, personal loans, and mortgages could also be vulnerable. Simple transactions like renting a car, which usually requires presentation of a credit card, could be seriously curtailed. Restaurant businesses would suffer as people would no longer be able to pay for their meals with credit.
Riley suggests that the political promise wouldn’t survive the fact-checking process.
“Prudent regulators stick to things like checking liquidity and checking performance,” Riley said. “But once politicians start telling lenders that they have to lend into money-losing propositions, it doesn’t make any sense.”
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